Purification Plastics Inc. was founded in East Grand Forks, Minnesota by Scott Dice and Daryl Enns in 1988. Both were undergraduate biochemistry students at the University of Minnesota. Scott went on for a Masters in Environmental Science at Oklahoma State and Daryl took his MBA at the University of Wisconsin - Milwaukee.
Scott had gone back to East Grand Forks to work in is father's well drilling and water service business, Dice Water Contractors. Within a month, Scott had noticed the difficulty in obtaining proper pipe for their projects and construction sites. Most of the pipe was an iron based metal composite. This presented two problems. First it was not "burst-proof" (needed in the cold weather) and second it was not flexible (needed for ease of installation). Scott thought that these problems could be solved with the new generation of plastic pipes that were becoming available in the market.
Within a month Scott was busy designing his own pipes for irrigation and water systems. In January of the following year he had set up a small pipe extrusion plant, Northern Pipe and Plastics to satisfy Dice Water's demand as well as some of the other small to medium size businesses in and around East Grand Forks that were in need of the similar materials. With in two years Plastics Pipe Dreams Inc. had become the top regional extruder of polyvinyl chloride (PVC) pipe products, with a reputation for reliability, high quality products and very responsive customer service.
Daryl Enns had found employment with WaterPur, a small water filtration company in Duluth, Minnesota. The owner of the WaterPur was forced to put the company up for sale due to health reasons in 1994. Daryl purchased the company and started designing a new water purification system based on ultraviolet light. This is a non-chemical process that can rid water of Chlorine, polychlorinated biphenyls, Lead, Ethylene Dibromide, Trichloroethylene, Coli form bacteria, trihalomethanes and tetradecylcyclobutanone as well as over fifty additional chemical contaminants and pesticides which are on the EPA's Primary Health Related Contaminants lists for drinkable water.
Daryl and Scott were joint contractors on a water system project in St Cloud, Minnesota in 1998, and both could see the advantages of merging the two entities into one company to be called Purification Plastics Inc.
With the new EPA regulations and consumer awareness of the quality of drinking water the company went through a rapid phase of expansion. The growth soon exhausted most of the capital with in the company and the principles were forced to raise money from external sources. In 2000 the company borrowed heavily by issuing bonds. When that source was nearing it maximum, the company then floated 10 million of preferred stock and 32 million of common stock. Currently the stock trades in the OTC and has a market price of $12.50 a share.
In 2003 Purification Plastics Inc. signed "an intent" (preliminary negotiation contract) with the US military to provide water purification equipment for eight of the domestic US military bases. This would require the company to once again obtain external financing. Given the nature of the contract and the risk of parties involved this should be no problem. However to properly price the new contract Purification Plastics Inc. has hired you to do some of the financial leg work.
Table 1
Purification Plastics Inc: balance Sheet for the year ending 2003
(In millions of dollars)
Cash and securities $ 2.1 Accounts Payable $ 1.2
Accounts Receivable 10.1 Accruals 1.5
Inventory 2.6 Notes Payable .5
Total Current Assets $ 14.8 Total Current Liabilities 3.2
Net Fixed Assets 29.1 Long-term Debt 15.0
Preferred Stock 4.0
Common Stock 1.0
Retained Earnings 20.7
Total Assets 43.9 Total Liabilities & Equity 43.9
The following data was also provided:
1) The company's long-term debt consists entirely of an 8% semiannual bond with 16 years remaining to maturity. The bonds last trading price was $1,205.00 per $1,000.00 bond. The bonds are not callable. Flotation cost on a new issue would be 7%.
2) In conversation with the owners, it was emphasized that short term debt was NOT an option.
3) The company's federal plus state tax rate is 34%.
4) The company's preferred stock pays a $3.50 dividend per quarter. It is non-callable and has a current market price of $133.60. Flotation cost on a new issue would be 10%.
5) The firm's last dividend was $1.55 per share. The dividends are expected to grow at a 6% annual rate for the foreseeable future. Purification's stock current market price is 14.25 per share. The par vale is 1.00 per share. Flotation cost on a new issue would be 12%.
6) Information from a market investment firm gives the firm's historical beta at 2.6. The investment banking firm also informed you that government T-Notes are expected to have a return of 5%. There is a 6% as the market risk premium.
7) The company wishes to retain the current capital structure for the foreseeable future.
Questions: Purification Plastics
1) What specific items should be included in the calculation of the company's cost of capital?
2) What are the weights (at the company's current market value) for each of the components that should be included?
3) What are the costs (at the company's current market value) for each of the components that should be included?
4) What is the company's current WACC?
5) What would be the cost of floating new 20 year semi-annual bonds?
6) What would be the cost of floating new P/S?
7) What would be the cost of floating new C/S?
8) What are the considerations for including a specific item in the calculation?
9) Why are a) Notes Payable, and b) Retained Earnings not included in the calculations? Is there a cost associated with either of there components?